Obligations when selling options – Option Trading FAQ

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Obligations when selling options

Q: I recently bought a call option. Since then, the stock price has risen and so has the call option. I wish to sell my call option for a profit but am I obligated to deliver the underlying stock if the option buyer decides to exercise his call option?

A: The short answer is “No”. You might have heard that options sellers have obligation to deliver the underlying stock. That is true only when you sell the call option as an opening transaction – also known as a sell-to-open transaction. In your case, it is a sell-to-close transaction, meaning you are selling the option to close out your open long call position and will no longer be a party in any contract and hence you are not obliged to deliver any stock.

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When does one sell a put option, and when does one sell a call option?

The incorporation of options into all types of investment strategies has quickly grown in popularity among individual investors. For beginner traders, one of the main questions that arise is why traders would wish to sell options rather than to buy them. The selling of options confuses many investors because the obligations, risks, and payoffs involved are different from those of the standard long option.

Key Takeaways

  • Selling options can be a consistent way to generate excess income for a trader, but writing naked options can also be extremely risky if the market moves against you.
  • Writing naked calls or puts can return the entire premium collected by the seller of the option, but only if the contract expires worthless.
  • Covered call writing is another options selling strategy that involves selling options against an existing long position.

Overview

In options terminology, “writing” is the same as selling an option, and “naked” refers to strategies in which the underlying security is not owned and options are written against this phantom security position. The naked strategy is aggressive and higher risk but can be used to generate income as part of a diversified portfolio. However, if not used properly, a naked call position can have disastrous consequences since a security can theoretically rise to infinity.

To understand why an investor would choose to sell an option, you must first understand what type of option it is that he or she is selling, and what kind of payoff he or she is expecting to make when the price of the underlying asset moves in the desired direction.

When Should I Sell A Put Option Vs A Call Option?

Selling Puts

An investor would choose to sell a naked put option if her outlook on the underlying security was that it was going to rise, as opposed to a put buyer whose outlook is bearish. The purchaser of a put option pays a premium to the writer (seller) for the right to sell the shares at an agreed upon price in the event that the price heads lower. If the price hikes above the strike price, the buyer would not exercise the put option since it would be more profitable to sell at the higher price on the market. Since the premium would be kept by the seller if the price closed above the agreed-upon strike price, it is easy to see why an investor would choose to use this type of strategy.

Example

Let’s look at a put option on Microsoft (MSFT). The writer or seller of MSFT Jan18 67.50 Put will receive a $7.50 premium fee from a put buyer. If MSFT’s market price is higher than the strike price of $67.50 by January 18, 2020, the put buyer will choose not to exercise his right to sell at $67.50 since he can sell at a higher price on the market. The buyer’s maximum loss is, therefore, the premium paid of $7.50, which is the seller’s payoff. If the market price falls below the strike price, the put seller is obligated to buy MSFT shares from the put buyer at the higher strike price since the put buyer will exercise his right to sell at $67.50.

Selling Calls

An investor would choose to sell a naked call option if his outlook on a specific asset was that it was going to fall, as opposed to the bullish outlook of a call buyer. The purchaser of a call option pays a premium to the writer for the right to buy the underlying at an agreed upon price in the event that the price of the asset is above the strike price. In this case, the option seller would get to keep the premium if the price closed below the strike price.

Example

The seller of MSFT Jan18 70.00 Call will receive a premium of $6.20 from the call buyer. In the event that the market price of MSFT drops below $70.00, the buyer will not exercise the call option and the seller’s payoff will be $6.20. If MSFT’s market price rises above $70.00, however, the call seller is obligated to sell MSFT shares to the call buyer at the lower strike price, since it is likely that the call buyer will exercise his option to buy the shares at $70.00.

Writing Covered Calls

A covered call refers to selling call options, but not naked. Instead, the call writer already owns the equivalent amount of the underlying security in his or her portfolio. To execute a covered call, an investor holding a long position in an asset then sells call options on that same asset to generate an income stream. The investor’s long position in the asset is the “cover” because it means the seller can deliver the shares if the buyer of the call option chooses to exercise. If the investor simultaneously buys stock and writes call options against that stock position, it is known as a “buy-write” transaction.

Covered call strategies can be useful for generating profits in flat markets and, in some scenarios, they can provide higher returns with lower risk than their underlying investments

The Bottom Line

Selling options can be an income-generating strategy, but also come with potentially unlimited risk if the underlying moves against your bet significantly. Therefore, selling naked options should only be done with extreme caution.

Another reason why investors may sell options is to incorporate them into other types of option strategies. For example, if an investor wishes to sell out of his or her position in a stock when the price rises above a certain level, he or she can incorporate what is known as a covered call strategy. Many advanced options strategies such as iron condor, bull call spread, bull put spread, and iron butterfly will likely require an investor to sell options.

Answers To Frequently Asked Questions On Selling Options

Forbes Premium Income Report

In Forbes Premium Income Report , we sell options for income. Sometimes we do what are known as buy writes, in which we buy a stock and simultaneously sell out-of-the-money call options against it. Other times, we sell out-of-the-money put options, which obliges us to buy the stock at the strike price if the stock finishes below the strike price at expiration. If the stock price remains above the strike price, we keep the money we earned from selling the options. Occasionally, we end up owning stocks after the options expire and we sell covered calls against the position.

Many subscribers have written to me with questions on the strategies we use and how best to utilize the service. In the interest of helping new and potential subscribers, I’ve listed five of the most frequently asked questions and answers below.

What would you say is a good cash starting point for beginning the ideas you mention in this newsletter? The average size of a recommended trade is about $6,000, and they range from $4,000 to $10,000. Because you have to buy at least 100 shares, or have cash set aside with your broker to buy it in the case of selling puts, you’re looking at committing at least $5,000 to any stock that trades for $50 per share and above. For a several-hundred dollar stock like AMZN, NFLX or PCLN would require tens of thousands (about $125 K for PCLN) to get involved with the options, since one contract covers 100 shares. Since I recommend two trades every Tuesday and Thursday, that’s 16 per month. Using my $6,000 average size, that comes out to $96k to get rolling for one month. Then when the options expire, mostly on the third Friday of each month, you have new cash to redeploy, or stocks to sell or hold. Kind of like farming. You could pick just half of the trades I recommend and $50,000 would be sufficient to get you going. Pick one out of four and $25,000 would be fine.

When selling put options, if the option is exercised, I am obligated to buy the security. Once I buy the stock, is there a minimum time that I have to hold the stock, or can I hold or sell the stock any time after the settlement date? Regarding having puts exercised, once the shares of the underlying stock are in your brokerage account, you can do whatever you’d like to do right away. What I like to do is to see what kinds of returns I can earn selling covered calls. If nothing expiring in the next few months provides at least a possible 15% annualized return, then I sit tight until something does develop while I’m hopefully collecting dividends, too.

Your website mentions selling covered calls. Is this a large part of your strategy? I don’t own significant stocks so I can’t participate in covered calls. The only time I send out a covered call recommendation is when it’s on a stock that we ended up owning after a prior expiation. When I send out the recommendations they are considered good to buy at the prices shown or better. Sometimes we end up owning a stock after the options expire, but we do so at a reduced cost basis thanks to the money received from selling the options, and we can repeat the premium income cycle again by selling call options against the stock. I group the recommendations into conservative and aggressive depending on the risk of the underlying stock. Before you put in the order, check to see that the current bid price of the options we are selling is at or near the price quoted in the recommendation. This way, you won’t put in a net debit limit order to do a buy write on a stock that has already tanked. You will probably get filled, but you’ll be angry, because you could have bought the stock and sold a lower-strike call for more money.

Please explain the process for entering a buy write order. You can do buy writes a couple of ways. Most brokerages offer specific buy write orders in which you select the number of shares of stock you want to buy and which call options you want to sell. You can put in the trade as a market order, and this will likely have you buying the stock at the ask price and selling the calls at the bid price. If the bid-ask spread is tight, this may not be a big deal, but if you have a wide bid-ask spread, it may be more appropriate to use a “net debit limit order.” The net debit is the amount you need to pay to establish the position, calculated as the price of the stock minus the price of the option you sell. By using a net debit limit you establish the maximum price you are willing to pay for the combination. If you want to sell call options for $1 apiece on a stock that trades at $30, you would use a net debit limit of $29.

Should I demand to receive the exact amount for the options I’m selling that you suggest or do I accept a little less income? What I am seeking is a 2% or so yield per month from the premium we collect dividend by the money at risk. If you can get that amount of premium, the trade makes sense. Always check the quote of the options that I recommend selling to see if you can sell them for more, or if you cannot get as high of a premium that I’ve recommended. Don’t stray too many pennies from the recommended prices because if the stock has moved a lot, the better trade may be a buy write at a lower strike price, or a put sale. I would think of these recommendations as pitches, and you’re the batter. If the pitch is not in your strike zone, you don’t need to swing at it. Don’t chase bad pitches. With two picks every Tuesday and Thursday, there’s always another opportunity coming down the pike.

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